CHAPTER 9

FOREIGN EXCHANGE MARKET

INTRODUCTION
Most countries of the world have their own currencies: The United States has its dollar;
France, the euro; Brazil, its real; India, its rupee and in the Philippines its peso. Trade between
countries involves the mutual exchange of different currencies (or, more usually, bank deposits
denominated in different currencies). When an American firm buys foreign goods, services, or
financial assets, for example, U.S. dollars (typically, bank deposits denominated in U.S. dollars)
must be exchanged for foreign currency (bank deposits denominated in the foreign currency).

The trading of currency and bank deposits denominated in particular currencies takes
place in the foreign exchange market. The volume of these transactions worldwide averages
over P1 trillion daily. Transactions conducted in the foreign exchange market determine the
rates at which currencies are exchanged, which in turn determine the cost of purchasing foreign
goods and financial assets.

Firms that do business internationally must be concerned with exchange rates, which
are the relationships among the values of currencies. For example, a Philippine firm selling
products in Europe will be very interested in the relationship of the Euro to the Philippine peso
as well as the US dollar.

The constant change in exchange rates causes problems for financial managers as the
change in relative purchasing power between countries affects imports and exports, interest
rates and other economic variables. The relative strength of a particular currency to other
currencies changes many times over a business cycle.

RECENT HISTORICAL PERSPECTIVE OF EXCHANGE RATES

From the end of World War II until the early 70's, the world was on a fixed exchange rate
system administered by the International Monetary Fund (IMF). Under this system, all countries
were required to set a specific parity rate for their currency vis-a-vis the United States dollar. A
country could effect a major adjustment in the exchange rate by changing the parity rate with
respect to the dollar. Then the currency was made cheaper with respect to the dollar, this
adjustment was called a devaluation. An upvaluation or revaluation resulted when a currency
became more expensive with respect to the dollar.
A floating rate international currency system has been operating since 1973. Most major
currencies fluctuate freely depending upon their values as perceived by the traders in foreign
exchange markets. The determination of exchange rates are influenced by such important
factors as (a) the country’s economic strengths, (b) its level of exports and imports, (c) the level
or monetary activity, and (d) the deficits or surpluses in its balance of payments. Short term,
day-to-day fluctuations in exchange rates are caused by supply and demand conditions in the
foreign exchange market.

THE FOREIGN CURRENCY EXCHANGE MARKET

The forex market provides a service to individuals, businesses, and governments who
need to buy or sell currencies other than that used in their country. This might be in order to
travel abroad, to make investments in another country, or to pay for import products or convert
export earnings.

It is also a marketplace in which currencies are bought and sold purely to make profit via
speculation. When trading very large volumes of currency, even small fluctuations in price can
provide profits or losses. The forex market is open 24 hours, 5 days a week, which makes it
unusual, as equity markets have set daily trading hours and are closed overnight.

The foreign exchange (or forex) market provides a mechanism for the transfer of
purchasing power from one currency to another. This is where traders convert one foreign
currency into another and is one of the largest financial markets in the world. Currency trading
entails no specific physical location; instead, it is an over-the-counter market whose main
participants are commercial and investments banks, and foreign exchange dealers and brokers
around the world. They communicate using electronic networks. Any firm's bank or experts
within the firm, can access this market to exchange one currency for another.

Some important commercial centers for foreign exchange trading are New York, London,
Zurich, Frankfurt, Hong Kong, Singapore and Tokyo.

Since this market provides transactions in a continuous manner for a very large volume
of sales and purchase, the currencies are efficiently priced; or one market is efficient. In short, it
is difficult to make a profit by shopping around from one bank to another. Minute differences in
the quotes from different bank are quickly arbitraged away. The concept of arbitrage will be
discussed later. Owing to the arbitrage mechanism, simultaneous quotes to different buyers in
London and New York are likely to be the same.
EXCHANGE RATES
An exchange rate is simply the price of one country's currency expressed in terms of
another country's currency. In practice, almost all trading of currencies takes place in terms of
the U.S. dollar. For example, both the Euros, the Swiss franc, and the Japanese yen are traded
with prices quoted in U.S. dollar. Exchange rates are constantly changing.

Foreign exchange rate quotations can be found in The Wall Street Journal, in other
leading print publications and on websites. A publication of the reference exchange rates
released by the Bangko Sentral ng Pilipinas as of August 27. 2019 is shown in Figure 9-1 below.
WHY ARE EXCHANGE RATES IMPORTANT?

Exchange rates are important because they affect the relative price of domestic and
foreign goods. The dollar price of French goods to an American is determined by the interaction
of two factors: the price of French goods in euros and the euro/ dollar exchange rate.

When a country's currency appreciates (rises in value relative to other currencies), the
country's goods abroad become more expensive and foreign goods in that country become
cheaper (holding domestic prices constant in the two countries). Conversely, when a country's
currency depreciates, its goods abroad become cheaper and foreign goods in that country
become more expensive.

Appreciation of a currency can make it harder for domestic manufacturers to sell their
goods abroad and can increase competition at home from foreign goods because they cost less.
FACTORS INFLUENCING EXCHANGE RATES
As with any other market, the exchange rate between two currencies is determined by
the supply of the demand for those currencies. The present international monetary system
consists of a mixture of “freely” floating exchange rates and fixed rates. The currencies of the
major trading partners of the United States are traded in free markets. This activity, however, is
subject to intervention by many countries central banks. Factors that tend to increase the
supply or decrease the demand schedule for a given currency will bring down the value of that
currency in foreign exchange markets. Similarly, the factors that tend to decrease the supply, or
increase the demand for a currency will raise the value of that currency. Since fluctuations in
currency values result in foreign exchange risk, the financial manager must understand the
factors causing these changes in currency values. Although, the value of a currency is
determined by the aggregate supply and demand for that currency, this alone does not help
financial managers understand or predict the changes in exchange rates.

The major reasons for exchange rate movements which include inflation, interest rates, balance
of payments, government's policies or intervention and so forth are discussed briefly in the
following sections.

1. Inflation. Inflation tends to deflate the value of a currency because holding the currency
results in reduced purchasing power.

2. Interest rates. If interest returns in a particular country are higher relative to other
countries, individuals and companies will be enticed to invest in that country. As a result,
there will be an increased demand for the country's currency.

3. Balance of payments. Balance of payments is used to refer to a system of accounts that

catalogs the flow of goods between the residents of two countries. For instance, if
Philippines is a net exporter of goods and therefore has a surplus balance of trade,
countries purchasing the goods must use the country's currency. This increases the
demand for the currency and its relative value.

4. Government intervention. Through intervention (e.g., buying or selling the currency in

the foreign exchange markets), the central bank of a country may support or depress the
value of its currency.

5. Other factors. Other factors that may affect exchange rates are political and economic
stability, extended stock market rallies and significant declines in the demand for major
exports.
HOW IS FOREIGN EXCHANGE TRADED
You cannot go to a centralized location to watch exchange rates being determined;
currencies are not traded on exchanges such as the New York Stock Exchange. Instead, the
foreign exchange market is organized as an over-the-counter market in which several hundred
dealers (mostly banks) stand ready to buy and sell deposits denominated in foreign currencies.
Because these dealers are in constant telephone and computer contact, the market
competitive; in effect it functions no differently from a centralized market.

An important point to note is that while banks, companies, and governments talk about
buying and selling currencies in foreign exchange markets, they do not take a fistful of dollar
bills and sell them for British pound notes. Rather, most trades involve the buying and selling of
bank deposits denominated in different currencies. So when we say that a bank is buying dollars
in the foreign exchange market, what we actually mean is that the bank is buying deposits
denominated in dollars.

INTERACTION IN FOREIGN CURRENCY MARKETS

Exchange Rate Determination

Equilibrium exchange rate in floating markets are determined by the supply of and demand for
the currencies.

Fixed Exchange Rate

An exchange rate set too high (in foreign currency units per peso) tends to create a deficit
Philippine balance of payments. This deficit must be financed by drawing down foreign reserves
or by borrowing from the central banks of the foreign countries. This effect is short-term
because at some time, the country will deplete its foreign reserves. A major reason for a
country’s devaluation is to improve its balance of payments. As an alternative to drawing down
its reserves, a country might change its trade policies or implement exchange controls or
exchange rationing. Many developing countries use currency exchange rationing to avoid a
deficit balance of payments.

An exchange rate set too low (in foreign currency units per peso) tends to create a surplus
Philippine balance of payments. In this case, surplus reserves build up. At some time, the
country will not want any greater reserve balances and will have to raise the value of its
currency.

An exchange rate A (PA foreign currency units per peso), a greater quantity of peso is supplied
by Philippine interests than demanded by foreign interests (i.e., Philippine imports exceed
exports). The result is a trade deficit. An exchange rate B, a smaller quantity of peso is supplied
by Philippine interests than demanded by foreign interests (i.e., Philippine exports exceed
imports). The result is a trade surplus.

Managed Float

A managed float is the current method of exchange rate determination. During periods of
extreme fluctuation in the value of a nation's currency, intervention by governments or central
banks may occur to maintain fairly stable exchange rates.

Floating rates permit adjustments to eliminate balance of deficits or surpluses. For example, it
the Philippine has a deficit in its trade with Japan, the Philippine peso will depreciate relative to
Japan's currency. This adjustment should decrease imports from and increase exports to Japan.
THEORY OF PURCHASING POWER PARITY
One of the most prominent theories of how exchange rates are determined is the theory of
purchasing power parity (PPP). It states that exchange rates between any two currencies will
adjust to reflect changes in the price levels of the two countries. The theory of PPP is simply an
application of the law of one price to national price levels.

To illustrate, if the law of one price holds, a 10% rise in the yen price of Japanese steel results in
a 10% appreciation of the dollar. Applying the law of one price to the price levels in the two
countries produces the theory of purchasing power parity, which maintains that is the Japanese
price level rises 10% relative to the U.S. price level; the dollar will appreciate by 10%. The theory
of PPP suggests that if one country's price level rises relative to another's, its currency should
depreciate (the other country's currency should appreciate).

The PPP conclusion that exchange rates are determined solely by changes in relative price levels
rests on the assumption that all goods are identical in both countries. When this assumption is
true, the law of one price states that the relative prices of all these goods (that is, relative price
level between the two countries) will determine the exchange rate.

PPP theory furthermore does not take into account that many goods and services (whose prices
are included in a measure of a country's price level) are not traded across borders. Housing,
land, and services such as restaurant meals, haircuts, and golf lessons are not traded goods. So
even though the prices of these items might rise and lead to a higher price level relative to
another country’s, there would be little direct effect on the exchange rate.

WHAT ARE THE FOREIGN CURRENCY EXCHANGE RATE TRANSACTIONS?

The two kinds of Foreign Exchange Rate Transactions are:

A. Spot Transactions

B. Forward Transactions

Spot Transactions

Spot transactions are those which involve immediate (two-day) exchange of bank deposits. The
spot exchange rate is the exchange rate for the spot transactions.

Forward Transactions
Forward transactions involve the exchange of bank deposits at some specified future date. The
forward exchange rate is the exchange rate for the forward transaction.

In major financial newspaper (e.g., Wall Street Journal), two exchange rates for most major
currencies are published – the spot rate and the forward rate.

SPOT EXCHANGE RATES

If we are exchanging one currency for another immediately, we participate in a spot transaction.
A typical spot transaction may involve a Philippine firm buying foreign currency from its bank
and paying for it in Philippine pesos (or an American firm buying currency from its bank and
paying for it in US dollar).

The price of the foreign currency in terms of the domestic currency is the exchange rate – in this
instance, the Philippine peso. Another case of a spot transaction is when a Philippine firm
receives foreign currency from abroad. The firm would typically sell the foreign currency to its
bank Philippine peso. These are both spot transactions, where one currency is exchanged for
another currency immediately. The actual exchange rate quotes are expressed in several ways,
as explained below.

The spot rate for a currency is the exchange rate at which the currency is traded for immediate
delivery. For example, if you walk into a local commercial bank, ask for US dollars. The banker
will indicate the rate at which the US dollar is selling, say P52.60 per US$1. If you like the rate,
you buy what you need and walk out the door. This is a spot market transaction at the retail
level.

DIRECT AND INDIRECT QUOTES

In the spot exchange market, the quoted exchange rate is typically called a direct quote. A direct
quote indicates the number of units of the home currency required to buy one unit of the
foreign currency. Figure 9-1 shows the spot rates and the direct exchange quotes the Philippine
Daily Inquirer on August 27, 2019.

The table above shows that in order to by one US dollar on August 27, 2019, P52.326 were
needed. In order to buy one Japanese yen and one UK pound on the same date, P.4931 and
P63.9424 were needed, respectively. The quotes in the spot market in New York are given in
terms of US dollars and those in European Union in terms of Euros.

An indirect quote indicates the number of units of foreign currency that can be bought for one
unit of the home currency. In summary, a direct quote is the peso/ foreign currency rate, and an
indirect quote is the foreign currency/ peso rate. Therefore, an indirect quote is the reciprocal
of a direct quote and vice versa.

(Source: Bangko Sentral ng Pilipinas Oficial Website (http://www.bspgovph))

ILLUSTRATIVE CASE
Compute the indirect quotes from the Philippine direct quotes of spot rates for US dollars, UK
pound, EU euros, and Japanese yen as of August 27, 2019 given in Figure 9-1. The related
indirect quotes are computed as follows:

Indirect Quote = 1/Direct Quote

Thus:

US dollars = 1/52.3260 = .01911 (dollor/P1)

UK pounds = 1/63.9424 = .01564 (pound/P1)

EU euros = 1/ 58.1028 = .01721 (euro/P1)

Japan yen= 1/.4931 = 2.028 (yen/P1)

The direct and indirect quotes are useful in computing foreign currency requirements. Consider
the following examples:

(a) A Filipino businessman wanted to remit 1,000 UK pounds to London on August 27, 2019.
How much in pesos would have been required for this transaction?

P63.9424P/pounds x 1,000 pounds = P63.942.40

(b) A Filipino businessman paid P112,148.20 to an Italian supplier on August 27, 2019. How
many euros did the Italian supplier receive?

P112,148.20 x 0.1721 =€1,930.07 euros

CROSS RATES
Also important in understanding the spot-rate mechanism is the cross rate. A cross rate is the
indirect computation of the exchange rate of one currency from the exchange rates of two other
currencies.

For instance:

The peso/pound and the euro/peso rates are given in Figure 9-1. From this information, we
could determine the euro/pound and pound/euro exchange rates.

We see that:

P63.9424=£1

P58.1028=€1

P63.9424/ P58.1028 = 1.1005 euro per 1 pound

Thus, the pound/euro exchange rate is:

P58.1028/ P63.9424= .90867 pound per 1 euro

Cross rate computations make it possible to use quotations in New York to compute, the
exchange rate between pounds, euros and so forth in other foreign currency exchange markets.
If the rates prevailing in London and Paris were different from the computed cross rates, using
quotes from New York, a trader could use three different markets and make arbitrage profits.
The arbitrage condition for the cross rates is called triangular arbitrage.

ARBITRAGE
The foreign exchange quotes in two different countries must be in line with each other. For
example, the direct quote for U.S. dollars in London is given in dollars/pound. Since the foreign
exchange markets are efficient, the direct quotes for the United States dollar in London, on April
25, 2019, must be very close to the indirect rate of .6691 pound/dollar prevailing in New York
on that date.

If the exchange-rate quotations between the London and New York spot exchange markets were
out of line, then an enterprising trader could make a profit by buying in the market where the
currency was cheaper and selling it in the dearer. Such a buy-and-sell strategy would involve an
investment of funds for a very short time and no risk bearing, yet the trader could make a sure
profit. Such a person is called an arbitrageur, and the process of buying and selling in more than
one market to make a riskless profit is called an arbitrage. Spot exchange markets are efficient
in the sense that arbitrage opportunities do not persist for any length of time. That is, the
exchange rates between two different markets are quickly bought in line, aided by the arbitrage
process.

Some people intentionally look for exchange rate mispricings by comparing direct quote
exchange rates between two currencies with cross rates determined through a third currency. If
direct quotes and cross rates differ, arbitrage – a form of buying low and selling high – is
possible.

Because three exchange rates are necessary to profit from a mispricing, this process is
sometimes called triangular arbitrage and as previously mentioned, the person doing it is called
an arbitrageur.

FORWARD RATES
The forward rate for a currency is the exchange rate at which the currency for future delivery is
quoted. The trading of currencies for future delivery is called a forward market transaction.
Suppose Sta. Lucia Corporation expects to pay US$1.0 million to a US supplier 30 days from
now. It is not certain however, what these dollars will be worth in Philippine pesos 30 days from
today. To eliminate this uncertainty, Sta. Lucia Corporation calls a bank and offers to buy US$1.0
million to a US supplier 30 days from now. In their negotiation, the two parties may agree on an
exchange rate of P46 million to the bank and receives $1 million.

The forward exchange rate could be slightly different from the spot rate prevailing at that time.
Since the forward rate deals with a future time, the expectations regarding the future value of
that currency are reflected in that forward rate. Forward rates may be greater than the current
spot rate (premium) or less than the current spot rate (discount).

The discount or premium is usually expressed as an annualized percentage deviation from the
spot rate.

Normally, the forward premium or discount is between 0.1 percent and 5 percent. The spot and
forward transactions are said to occur in the over-the-counter market. Foreign currency dealers
(usually large commercial banks) and their customers (importers, exporters, investors,
multinational firms and so forth) negotiate the exchange rate, the length of the forward
contract and the commission in a mutually agreeable fashion. Although the length of a typical
forward contract may generally vary between one month and six months, contracts for longer
maturities are not common. The dealers, however, may require higher returns for longer
contracts.
FACTORS THAT AFFECT EXCHANGE RATES IN THE LONG RUN
Our analysis indicates that relative price levels and additional factors affect the exchange rate. In
the long run, there are four major factors: relative price levels, tariffs and quotas, preferences
for domestic versus foreign goods, and productivity.

Relative Price Levels

In the long run, a rise in a country's price level (relative to the foreign price level) causes
its currency to depreciate, and a fall in the country's relative price level causes its
currency to appreciate.

Trade Barriers

Increasing trade barriers causes a country’s currency to appreciate in the long run.

Preferences for Domestic Versus Foreign Goods

Increased demand for a country's exports causes its currency to appreciate in the long
run; conversely, increased demand for imports causes the domestic currency to
depreciate.

Productivity

In the long run, as a country becomes more productive relative to other countries, its
currency appreciates.

EXCHANGE RATES IN THE SHORT RUN

The key to understanding the short-run behavior of exchange rates is to recognize that an
exchange rate is the price of domestic bank deposits (those dominated in the domestic
currency) in terms of foreign bank deposits (those denominated in the foreign currency).
Because the exchange rate is the price of one asset in terms of another, the natural way to
investigate the short-run determination of exchange rates is through an asset market approach
that relies heavily on our analysis of the determinants of assets demand.

Earlier approaches to exchange rate determination emphasized the role of import and export
demand. The more modern asset market approach used here does not emphasize the flows of
purchases of exports and imports over short periods because these transactions are quite small
relative to the amount domestic and foreign bank deposits at any given time. Thus, over short
periods such as a year, decisions to hold domestic or foreign assets play a much greater role in
exchange rate determination than the demand for exports and imports does.

MANAGING FOREIGN EXCHANGE RISK

Foreign exchange risk refers to the possibility of a drop in revenue or an increase in cost in an
international transaction due to a change in foreign exchange rates. Importers, exporters,
investors and multinational firms are all exposed to this foreign exchange risk.

When the parties associated with a commercial transaction are located in the same country, the
transaction is denominated in a single currency. International transactions inevitably involve
more than one currency (because the parties are residents of different countries). Since most
foreign currency values fluctuate from time to time, the monetary value of an international
transaction measured in either the seller's currency or the buyer's currency is likely to change
when payment is delayed. As a result, the seller may receive less revenue than expected or the
buyer may have to pay more than the expected amount for the merchandise.

International business transactions are denominated in foreign currencies. The rate at which
one currency unit is converted into another is called the exchange rate. In today's global
monetary system, the exchange rates of major currencies are fluctuating rather freely. These
“freely” floating exchange rates expose multinational business firms to foreign exchange risk. To
deal with this foreign currency exposure effectively, the financial manager must understand
foreign exchange rates and how they are determined. Foreign exchange rates are influenced by
differences in inflation rates among countries, differences in interest rates, government policies
and the expectations of the participants in the foreign exchange markets.

AVOIDANCE OF EXCHANGE RATE RISK IN FOREIGN CURRENCY MARKETS

The international financial manager can reduce the firm's foreign currency exposure by hedging
in the forward exchange markets, money markets and currency future markets.

1. The firm may hedge its risk by purchasing or selling forward exchange contracts. A firm
may buy or sell forward contracts to cover liabilities or receivables, respectively,
denominated in a foreign currency. Any gain or loss on the foreign payables or
receivables because of changes in exchange rates is offset by the loss or gain on the
forward contract.
2. The firm may choose to minimize receivables and liabilities denominated in foreign
currencies.

3. Maintaining a monetary balance between receivables and payables denominated in a

particular foreign currency avoids a net receivable or net liability position in that
currency. Monetary items are those with fixed cash flows. A firm may attempt to achieve
a net monetary debtor (creditor) position in countries with currencies expected to
depreciate (appreciate). Large multinational corporations have established multinational
netting centers as special departments to attempt to achieve balance between foreign
receivables and payables. They also enter into foreign currency futures contracts when
necessary to achieve balance.

4. Another means of managing exchange rate risk is by the use of trigger pricing. Under
trigger pricing, foreign funds are supplied at an indexed price but with an option to
convert to a future-based fixed price when a specified basis differential exists between
the two prices.

5. A firm may seek to minimize its exchange-rate risk by diversification. If it has

transactions in both strong and weak currencies, the effects of changes in rates may he
offsetting.

6. A speculative forward contract does not hedge any exposure to foreign currency
fluctuations, it creates the exposure.